Magazine

U.S.: Inflation Backs The Fed Into A Corner

July 02, 2006

It sure does look like a smoking gun. Up to now, an inflation problem was hard to pin down, except at the gas pump. The May consumer price index changed all that. It showed that inflation, even outside of energy and some quirky readings on housing costs, is picking up much faster than almost anyone had expected a few months ago. Most important, this new evidence changes the outlook for Federal Reserve policy and heightens the risks for the economy.

Rest assured, inflation is not about to rocket out of control. Competition both at home and abroad is too stiff to allow the kind of wage/price spiral that took off in the late 1960s. Businesses remain under intense pressure to lift earnings by controlling their costs, especially for labor. And they are doing it with productivity gains, not by simply jacking up prices.

But the price indexes do show that the U.S. is more inflation-prone now than it was during the inflation scare in the late 1990s. Now, as then, U.S. labor markets are tight and capacity use is high. But this time, the global economy is booming. That offers less of a safety valve for price pressures, compared with the capacity glut outside the U.S. back then. Also, the dollar is still considerably lower now, meaning less restraint on import prices. The biggest difference is $70 per barrel oil, an enormous cost pressure on many businesses.

May's consumer price index turned inflation worries into inflation reality. The core CPI, which excludes energy and food to capture inflation's broader trend, rose 0.3% from April. That was the third consecutive monthly advance of this size, which hasn't happened in more than a decade. Monthly increases of that magnitude are significant, because if extended over a year, they would yield a 3.7% annual rate. As it stands, the 12-month rate of core inflation in May was 2.4%, up from 2.1% in January, but the pace during the first five months of the year has been far faster.

WHAT'S POTENTIALLY TROUBLING for the outlook is the Fed's response to all this. The Fed's goal has been to find the level of interest rates that will bring down the economy's growth rate just enough to restrain inflation but not so much as to harm the economy. Economists call this manuever a soft landing, and the chances of pulling it off had been looking good. Now, with inflation visibly accelerating, the process could turn into a real nail-biter. Tighten too little, and the economy and inflation keep soaring. Tighten too much, and the economy crashes into a recession. History is a good guide here. If the Fed errs, it will be on the side of too much restraint, not too little.

That's especially true now. The Fed is not only battling inflation. Under new Chairman Ben S. Bernanke, it is also striving to maintain its credibility as an inflation fighter at a time when Wall Street needs reassuring. The Fed's favored inflation gauge is already exceeding the 1% to 2% comfort zone of several Fed officials, and recent economic data offer little assurance that the economy is slowing enough to vent growing inflation pressures. Policymakers are talking tough, and any failure to back up that talk with action would be viewed as backsliding.

Many Fed watchers who had thought the Fed would be finished hiking rates when its target rate hit the current 5% level are now lifting their forecast to 5.5%. Economists at Lehman Brothers (LEH), who expected the rate to top out at 5.5%, are now looking at 5.75%, and the research team at JPMorgan Chase (JPM) has boosted its forecast to 6%. With the target rate already on the high side of neutral -- the level that neither spurs nor restricts growth -- policy will most likely be in the restrictive range this summer for the first time since the late 1990s.

SOME ANALYSTS ARE STARTING to worry that the Fed may end up overreacting. Much of the recent speedup has been due to rising housing costs, which may have more to do with how they are measured than an actual trend. The government uses changes in rents, instead of house prices and interest rates, as a proxy for the cost of homeownership. Rents have risen because more people are renting now that it's more difficult to afford a home. This measurement, though, gives the counterintuitive sense that housing costs are rising while the housing market is weakening.

But it's not just the housing quirk. So far this year, these rent-based housing costs are rising at a 4.6% annual rate, up sharply from 2.5% for all of 2005. Because they account for a large 30% of the core CPI, they have contributed nearly 70% of this year's speedup in core inflation. Over the past three months these costs have risen even faster, but their contribution has been a smaller 58%. That means that since February, core inflation has picked up even outside of housing.

And it's not just the CPI. During the first five months of the year, the core producer price index for finished goods is rising at a 3.2% annual rate, more than twice as fast as the pace for all of 2005. Further back in the production pipeline, core prices for semi-finished goods have also accelerated. Even further back, costs of raw materials and supplies are up sharply. Prices of imported goods excluding fuels are increasing at a 3.2% rate, three times faster than last year.

PERHAPS MOST IMPORTANT, the Fed's preferred inflation gauge, the core price index for personal consumption expenditures (PCE), is also speeding up. This measure differs from the CPI in several ways, but the most important difference for now is that housing costs have a much smaller weight. Even if the core PCE index rises a modest 0.2% per month over the next three months, which is becoming an increasingly conservative scenario, the Fed's favored measure will show a 12-month rate of 2.5% by August. In February, the Fed's forecast for all of 2006 by this gauge called for core inflation of "about 2%."

One big plus for the Fed, so far, is that inflation expectations remain relatively low. If consumers and businesses start to build expectations of higher inflation into their buying and wage-setting decisions, then the classic wage/price spiral could take off.

Two key measures showed expected inflation coming down in June after picking up in April and May. The University of Michigan's June survey of consumer attitudes showed a decline in both short- and long-term expectations. Also, the spread between the yields on a 10-year Treasury note and a comparable Treasury inflation protected security (TIPS) has narrowed in recent weeks. This spread remains in the narrow range it has been in for the past 2 1/2 years.

Even so, keep in mind that people form expectations of inflation based on what is actually happening in the economy. That's why the pressure on the Fed to manage these expectations is increasingly heavy right now amid the new evidence that inflation is starting to accelerate. The Fed has little choice but to keep on raising interest rates until there are convincing signs that the economy is slowing down. That's the only way to assure that current inflation pressures will eventually recede.